Why Some States Don’t Allow P2P Lending Investments

It is a question the customer service people at Prosper and Lending Club hear all the time. Why doesn’t my state allow me to invest? Now, I am not an attorney but I have been doing some research that I think many readers will find useful. I have found out that unfortunately, there is no one answer to that question.

I spent some time in the past couple of weeks talking with all kinds of people on this topic. I have spoken with people at Lending Club and Prosper and also with the securities regulators in several states. I came away from these discussions feeling somewhat negative about the whole thing.

In some ways I feel sorry for the legal people at Lending Club and Prosper. Every state has different requirements and some states make it so difficult that they are effectively excluding themselves from p2p investors. As laws stand right now it would be virtually impossible for any p2p lender to create a model that would please every state. So, what are the problems with the states that don’t allow p2p lending?

No Investing Allowed in P2P Lending in Ohio

To give an example I will focus first on Ohio where I spoke with Mark Heuerman, Registration Chief Council of the Ohio Securities Division. He has written a report on p2p lending that he presented at last year’s Ohio Securities Conference so he is very familiar with Lending Club and Prosper.

The problem in Ohio is all about potential fraud. Under the Ohio Securities Act, Ohio views the borrower as the actual issuer of the notes – not Lending Club or Prosper. Like any other notes issued to Ohio investors, they need to know that the issuer is not making any fraudulent claims. Because both Lending Club and Prosper do not verify all information entered by borrowers they can make no such claim. How can they? It would be a virtually impossible task to verify the statements of every borrower (not just the financials but anything stated by a borrower) and certainly one that doesn’t scale.

If you want to read an attorney’s take on this then read this short post on the Business Law Prof blog from earlier this month, by University of Akron associate professor, Stefan Padfield. He explains clearly why p2p lending will not be available in Ohio any time soon.

Texas Hold ‘Em

In Texas it is a slightly different story. When I spoke with the securities regulators there they said they have no application on file for Lending Club but Prosper’s application is still pending, as it has been for about three years now. But their issue is slightly different than Ohio. Texas has similar merit review guidelines to Ohio but they focus on who exactly is responsible for the repayment of these loans.

They did not mention a concern about fraud but they wanted to know that the borrower has the ability to repay the loan. The only way they can be assured of that is to verify all the financial information of each borrower individually. Again this is technically unfeasible although not as impossible as Ohio’s demands. Texas did say that there is a potential workaround: if Prosper could issue and guarantee payment of the loans then they would consider approving the application. But obviously that is not going happen.

I also spoke with regulators in Iowa and Vermont. With Iowa they said they have received applications from Lending Club and Prosper; they have made comments on these applications, but have not heard back from either company. Vermont also has merit review guidelines that would require every new loan to be registered with them in a certain way; again this is something that Lending Club and Prosper are likely unwilling to do.

But What About the Secondary Market

The secondary market is interesting. Prosper only allows investing in the secondary market in the same states where the primary market is available, but Lending Club interprets things differently. According to Lending Club’s general counsel there is a different set of laws that govern the secondary market and the primary market. Take Texas for example. Their main problem is around the issuance of loans. Once these loans are issued it seems that they can be traded freely by Texas residents.

Prosper cannot comment on Lending Club’s decision to allow the secondary market in Texas and other states as they don’t allow this. But it seems to me that Prosper is taking a more conservative approach. However, Lending Club’s general counsel was very confident that current laws allow a secondary market in p2p lending notes in Texas and other states.

What Can You Do?

If you are a resident in one of the disallowed states you can take some action that will bring this issue into the spotlight. I would start by calling your state securities regulator. To find out how to contact them you can visit the North American Securities Administrators Association (NASAA) website and click on your state. This will provide a contact number for your state securities regulator. You can find out from them what specific issue prevents investment in p2p lending securities in your state.

It is the job of state securities regulators to enforce state laws. State laws are written by state politicians, so if you really want to take action then this is where you should go next. Find out who chairs the state committees that draft securities law, it is likely a committee that overseas financial institutions. Then contact these committee members and explain the problem. You could also contact your local state member for both the legislature and the senate.

If you can get your spouse, relatives and friends to also call the same state representatives that would also be helpful. We live in a great democracy and you should let your voice be heard. It is unlikely that the laws will change unless state representatives start hearing from a large number of people. For those people in states with particularly onerous laws this is really the best way to try and affect change.

Report Coming from the GAO Next Month

Having said all this, there may be a small ray of hope on the horizon. The Government Accountability Office is scheduled to release their report on peer to peer lending next month. While this will not change any laws it will provide recommendations on how peer to peer lending should be regulated. We can only hope it contains good news for p2p lending investors. But knowing how Congress works we are probably a long time away from any meaningful changes to existing laws.

One final comment I will make about all this. These state laws are designed to protect investors, I understand that. But state laws in Ohio, Texas or anywhere else would have permitted me to put my entire life savings into General Motors stock in 2007 when it was trading at around $30 and still seemed like a relatively safe investment. If I didn’t sell I would have lost my entire investment when GM declared bankruptcy.

Prosper and Lending Club have a track record now of producing great returns for investors while operating in an open and transparent way. They deserve better treatment by some state regulators.

@KenL/@Bill, Thanks – it is something I have been curious about myself for some time. Bill, if you are really keen to give p2p lending a try I know there are other avenues for accredited investors. Shoot me an email if you are interested.

The problem is likely not even those that right the laws, its the people that interpret the laws. You and I can read the same law two different ways. If the states see a way to generate some revenue from p2p lending, I can see changes coming more quickly.

@Jason, Thanks. You have hit the nail on the head as to why there has not been much movement here. There is nothing in it for state regulators to allow p2p lending in their states, they may as well err on the side of caution because they have nothing to lose by doing so.

Good article overall, though I don’t think the point about GM stock is a valid argument. The laws are designed to ensure quality of information and thus allow investors to make their own best decision with that information at hand. The laws did guarantee that with GM, as in your example, so a choice by someone to take those financials and invest in them would’ve been their choice alone and their mistake. The laws aren’t designed- nor should they be- to protect investors against all loss, just against shady practices and bad information, so to make that line of reasoning invalidates your argument. I agree with their attempt (and intent) to give investors the best quality information and I also agree with you that they need to be flexible in that interpretation of the law in cases like p2p lending. But then again, any argument against these laws (and any attempt to overturn or change them), needs to address their concerns – and methodology – of protecting investors. In other words, how can we prove that Propser/LC provide the same level of protection? Simple metrics like their default rates being in-line with major creditors are a good place to start.

@Shawn, Thanks for chiming in. I was merely making the point that regulators cannot protect investors from all losses, but I will agree that the laws are not designed for this purpose. You raise a good point about addressing regulator concerns. Regulators are not out to try and prevent Lending Club and Prosper from doing business, they are just doing what they think is right to protect investors.

Your point about legal interpretation is a good one. I would bet that within the 50 states there are some very similar laws in place. Some securities regulators have interpreted them one way and allowed p2p lending and others have interpreted differently. The underlying law may well have very similar wording.

I wonder did you make contact with any consumer credit state agencies? I know at least Prosper is still licensed in multiple states for its consumer credit related acitivities as well as securities activities. Sometimes the consumer credit regulators are separate from securities regulators, as they are likely enforcing a separate set of laws. I just wonder whether other regulators in the states you mention are also chiming in to keep p2p lenders out for various reasons under the ‘credit’ aspect as well.

@Jim, I did not make contact with the consumer credit agencies when working on this story. I think they are the agency that determines whether or not borrowers from a particular state are allowed. But from the borrower side of things there is much more openness to the concept. The most restrictive practices I see are for the investor side of things and that is under the securities regulators.

Peter,
If I am in a state (i.e. TX) where p2p lending is not allowed, can I open a private mailbox in another state and use that as my address? I haven’t opened up an account with LC or Propser yet, but I’m wondering (for a lender/investor) if they verify your address, etc… during the account setup.

The private mailboxes (MailBoxes,etc..) have services where they forward mail to you. Plus the mailing address usually appears to be a normal non-PO Box style mailing address. Any comments on this?

Plus, if I did this to get an account and ran into troubles later with borrowers not paying, would it pose a problem later if they found I was in a state not allowed? On the other hand, would it be a problem if I was a US resident living overseas and using a private mailbox to set up a LC or Prosper account?

@Mark, My understanding is that while neither LC or Prosper will verify your address during account setup you are violating their terms of agreement if you are not a resident in one of the approved states.

But a borrower should never be able to find out the identity of any of the investors so that would not be an issue.

Interesting article. The key really is that Lending Club and Prosper are unable to verify the veracity of the borrowers. This is a much bigger problem than appears on the surface because fraud is and should be a very real concern. Especially under the Prosper auctions, quite a number of loans were issued followed by prompt defaults. These alone suggest fraud is a risk. The lending models do have to be improved from where they are today to reduce fraud.

@Willy05, Fraud is definitely a major concern at both Lending Club and Prosper as well as for investors. I know Prosper have tightened up their underwriting strategies dramatically since the early days of their auction format and fraud is no longer the problem it once was. However, most long time investors have been burned occasionally by a borrower taking out a big loan and then declaring bankruptcy within a month or two.

But I believe the underwriting models have improved dramatically, such that I am not too concerned about fraud any more. It does happen but it is a very small percentage of borrowers today.

@Sam, I have spoken with the legal people at Lending Club about this and their feeling is that if the investor lives in a state that does not allow direct investing then they cannot invest. This is even if they form an LLC or partnership in a different state.

@Matt, I am not a lawyer but I did speak with LC’s legal counsel about this matter and he said something along the lines of as far as the SEC is concerned it doesn’t matter whether you invest through an LLC or as an individual – you still need to abide by the state laws of where your primary residence is.

“Both entities previously applied a number of years ago to register their securities in Arizona but those applications never reached the approval stage as I understand each offering did not meet the registration qualifications relating to the ability to service the debt. Please be advised the Division had not reached any final decision regarding these applications and both applications remain pending.”

@Mike, Thanks for providing this. This sounds similar to the Texas argument – they want to know that the borrower has the ability to pay. I think the reason that the applications are pending is because LC and Prosper realize they are not going to get a favorable ruling so why bother continuing.

It’s interesting that Texas hasn’t allowed it yet because it is quite easy to get a CSO going and start giving out loans for title and payday lending. P2P seems to be a “cleaner” investment strategy relative to these subprime products and the investment would be controlled by a large and accountable entity – aka prosper or lending club. I also imagine that defaults on a P2P loan is much less on average when comparing them to a payday loan. So you’d think they would give a faster approval if they are concerned about a consumer’s ability to pay back their loans.

So, if Texas is concerned that the P2P lender cannot verify that the borrower has the ability to repay the note, even if they pull credit reports, verify employment, bank accounts, income and everything a bank or credit union does, why is it that banks and credit unions can make loans but not a P2P investor through a company like Prosper or LC? Doesn’t sound equal to me.
And, what’s so wrong with P or LC letting both the borrower and the investors know who eachother is, which seems to be a SEC sticking point?

Bill, There are many, many things wrong the investor and borrower knowing each other. That is simply never going to happen at Lending Club and Prosper. The trouble is that individual investors could take it upon themselves to do collections and they may not adhere to the letter of the law. There is also the potential of discrimination occurring between investors and borrowers during the investing process.

But as a Texas investor you may have the opportunity to invest in Lending Club next year. They are planning an IPO and once that happens investors should be able to invest from all 50 states.

While I don’t know the laws here exactly, it is against Lending Club’s and Prosper’s terms of service to use an address that isn’t your own home address. Having said that I know many investors who do just that but I cannot condone this activity.

As I have said above, this will all be a moot point for Lending Club investors once they do an IPO which is expected in mid-2014. Investors from all 50 states will be eligible to invest then.

Peter, what would you say the odds are that Lending Club will actually do the IPO? I was planning to move to Texas until I read your post here. Very disappointing. It’s now mid-2014 and still nothing official with the IPO. Thanks again for sharing.

Derek, I would say the odds of Lending Club doing the IPO some time in 2014 are very high. They continue to keep talking about it, although they have pushed their date back from mid-2014. Unless something dramatic happens to the stock market I will be very surprised if we don’t see a Lending Club IPO in the next six months.

Any update on when we might be allowed to do P2P lending in Massachusetts, either with Prosper or Lending Club? Is Lending Club on schedule for their approval for 50 states next year? I am frustrated at being left out!

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